Three businesswomen in finance comparing NPVs (net present values)" width="1024" height="800" />Three businesswomen in finance comparing NPVs (net present values)" width="1024" height="800" />
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NPV, or net present value, is how much an investment is worth throughout its lifetime, discounted to today’s value. The NPV formula is often used in investment banking and accounting to determine if an investment, project, or business will be profitable in the long run.
Net present value is used to determine whether or not an investment, project, or business will be profitable down the line. The NPV of an investment is the sum of all future cash flows over the investment’s lifetime, discounted to the present value.
Companies often use net present value in budgeting to decide how and where to allocate capital. By adjusting each investment option or potential project to the same level — how much it will be worth in the end — finance professionals are better equipped to make informed decisions.
To calculate NPV, you have to start with a discounted cash flow (DCF) valuation because net present value is the end result of a DCF calculation.
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Corporate finance professionals commonly use net present value. For example, investment bankers compare net present values to determine which merger or acquisition is worth the investment. Additionally, some accountants, such as certified management accountants, may rely on NPV when handling budgets and prioritizing projects.
Business owners can also benefit from understanding how to calculate NPV to help with budgeting decisions and to have a clearer view of their business’s value in the future.
To calculate net present value, you need to determine the cash flows for each period of the investment or project, discount them to present value, and subtract the initial investment from the sum of the project’s discounted cash flows.
The NPV formula is:
In this formula:
Cash flows are any money spent or earned for the sake of the investment, including things like capital expenditures, interest, and loan payments. Each period’s cash flow includes both outflows for expenses and inflows for profits, revenue, or dividends.
The number of periods equals how many months or years the project or investment will last. Sometimes, the number of periods will default to 10, or 10 years, since that’s the average lifespan of a business. However, different projects, companies, and investments may have more specific timeframes.
In most situations, the discount rate is the company’s weighted average cost of capital (WACC). A company’s WACC is how much money it needs to make to justify the cost of operating. WACC includes the company’s interest rate, loan payments, and dividend payments.
Cash flows need to be discounted because of a concept called the time value of money. This is the belief that money today is worth more than money received at a later date. For example, $10 today is worth more than $10 a year from now because you can invest the money received now to earn interest over that year. Additionally, interest rates and inflation affect how much $1 is worth, so discounting future cash flows to the present value allows us to analyze and compare investment options more accurately.
The initial investment is how much the project or investment costs upfront. For example, if a project initially costs $5 million, that will be subtracted from the total discounted cash flows.
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Net present value has three potential outcomes:
Let’s assume your company has two potential projects it can start. How can we decide which project is the better option?
Your company’s weighted average cost of capital is 7%, so 7% will be the discount rate for both projects. Each project lasts five years. The initial investment and cash flows for the two projects are:
Discounting these cash flows using the 7% weighted average cost of capital, the annual discounted cash flows for each project are:
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